The pundits are finally convinced that the government is serious about deregulating diesel prices. Though the government has given its nod to oil marketing companies (OMCs) to raise diesel prices by 40-50 paise every month until losses borne by them are wiped out, many market participants were a bit sceptical of its implementation.

However, the latest price hike of 45 paise last week has given some credibility to the process. OMCs had raised diesel prices earlier once on January 18, too. Sure, it will naturally benefit OMCs, but it could be a slight dampener for automobile manufacturers, who had seen a sharp rise in demand for diesel cars due to the price differential in petrol and diesel.

"If OMCs increase the price of diesel every month, and petrol prices remain stable in the longer run, the price differential between petrol and diesel could narrow. This could reduce the attractiveness of diesel vehicles, and companies that have a high portfolio of diesel engine vehicles could lose out," says Manish Vaswani, an analyst at Morningstar India.

Some impact of this government policy is already visible in stock prices of companies in these segments. Over the last one year, BPCL is up from Rs301 to Rs380, a gain of 26%; ONGC has moved up from Rs287 to Rs321, up 12%; while IOC has moved up from Rs276 toRs315, a rise of 14%. On the other hand, truck and bus maker Ashok Leyland is down fromRs29 to Rs23, a fall of 21%.

BUY OMCS WITH A TWO-YEAR PERSPECTIVE

OMCs have been out of favour with investors for sometime now. Since they were subject to government policies and there was little clarity on the subsidy sharing mechanism, the time and mode of repayment of subsidy by the government, these stocks saw their valuations eroding slowly. BPCL trades at a price to earnings (P/E) ratio of 9, while ONGC commands a P/E of 11.87.

"Most oil marketing companies are available at a fraction of what it would take to replace them," say Vijay Kedia, managing director, Kedia Securities. The current move of raising diesel prices could change things. Due to a rise in retail prices, upstream companies like ONGC and Oil India stand to benefit more as their subsidy sharing will reduce. "ONGC's profit after tax could increase by 17% due to aRs22,000-crore reduction in under recoveries," says Amit Mishra, Sr-VP (energy) at Axis Capital, in a note to clients.

Oil marketing companies like BPCL, HPCL and IOC will benefit as their interest burden will come down, and cash flows will improve. Despite these benefits, analysts do not see much room for the stock prices to move up in the short-term. Rising crude prices and government policies continue to worry investors.

Brent crude prices have already moved up from $110 per barrel to $118.91, over the last 45 days. "Even after the rise in prices, companies are losing anywhere between Rs9 and Rs10 per litre on diesel," says J Venkatesan, fund manager at Sundaram Mutual Fund.

"With elections only a year away, political compulsions may hold the government back from raising oil prices or going slow on this," says Madhumita Ghosh, head of research at Unicon Financial Intermediaries. Hence her recommendation is to buy these stocks on declines, with an objective of holding for two years.

EFFECT ON AUTO MANUFACTURERS

Petrol prices have moved up from Rs51.68 per litre in February 2010 to Rs75.5 now, a rise of 46% in three years. As compared to this, diesel prices have moved up from Rs39.6 to Rs54.41, a rise of 37%. This differential in fuel prices led to a higher demand for such vehicles.

With crude prices continuing to remain high, this differential continues. Petrol prices have been raised again by Rs1.5 per litre on February 15. Hence the price differential between petrol and diesel continues. This means diesel cars will continue to be in demand in the near term. Â However, if the government continues with this policy of raising diesel prices every month, over the longer term, even if crude prices stabilise, diesel prices would continue to rise. This will lower the price difference between the two fuels, which could hit the demand for companies which have a higher component of diesel vehicles in their portfolio.

Analysts, however, say that besides fuel prices, vehicle demand also depends on interest rates and economic growth. Growth is slow and interest rates have not come down for borrowers. This has led to lower vehicle sales. This is reflected in the sales number for January 2013 when car sales were down 15.45% as compared to January 2012.

"With an economic recovery away, investors should not be in a hurry to buy automobile stocks. Look for a turn in the economic cycle before buying these stocks," says Alok Ranjan, portfolio manager at Way2Wealth.